10-Q 1 a08-18147_110q.htm 10-Q

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended May 31, 2008

 

OR

 

¨

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                 to               

 

Commission file number 1-9466

 

Lehman Brothers Holdings Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

13-3216325

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

 

 

745 Seventh Avenue, New York, New York

 

10019

(Address of principal executive offices)

 

(Zip Code)

(212) 526-7000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

 

As of June 30, 2008, 694,401,926 shares of the Registrant’s Common Stock, par value $0.10 per share, were outstanding.

 

 

 


 

[This page intentionally left blank.]

 


 

LEHMAN BROTHERS HOLDINGS INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED May 31, 2008

 

Contents

 

 

 

 

Page

 

 

Number

 

 

 

Available Information

3

 

 

 

Part I. FINANCIAL INFORMATION

 

 

 

 

Item 1.  Financial Statements—(unaudited)

 

 

 

 

Consolidated Statement of Income—

 

Three and Six Months Ended May 31, 2008 and 2007

4

 

 

 

Consolidated Statement of Financial Condition—

 

May 31, 2008 and November 30, 2007

5

 

 

 

Consolidated Statement of Cash Flows—

 

Six Months Ended May 31, 2008 and 2007

7

 

 

 

Notes to Consolidated Financial Statements

8

 

 

 

Report of Independent Registered Public Accounting Firm

53

 

 

 

Item 2.    Management’s Discussion and Analysis of

 

Financial Condition and Results of Operations

54

 

 

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

109

 

 

 

Item 4.    Controls and Procedures

109

 

 

 

Part II. OTHER INFORMATION

 

 

 

 

Item 1.    Legal Proceedings

110

 

 

 

Item 1A. Risk Factors

112

 

 

 

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

113

 

 

 

Item 4     Submission of Matters to a Vote of Security Holders

114

 

 

 

Item 6.    Exhibits

115

 

 

 

Signatures

117

 

 

 

Exhibit Index

118

 


 

LEHMAN BROTHERS HOLDINGS INC.

 

AVAILABLE INFORMATION

 

Lehman Brothers Holdings Inc. (“Holdings”) files annual, quarterly and current reports, proxy statements and other information with the United States Securities and Exchange Commission (“SEC”). You may read and copy any document Holdings files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, U.S.A. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330 (or 1-202-551-8090). The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Holdings’ electronic SEC filings are available to the public at http://www.sec.gov.

 

Holdings’ public internet site is http://www.lehman.com. Holdings makes available free of charge through its internet site, via a link to the SEC’s internet site at http://www.sec.gov, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the SEC. Holdings also makes available through its internet site, via a link to the SEC’s internet site, statements of beneficial ownership of Holdings’ equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.

 

In addition, Holdings currently makes available on http://www.lehman.com its most recent annual report on Form    10-K, its quarterly reports on Form 10-Q for the current fiscal year, its most recent proxy statement and its most recent annual report to stockholders, although in some cases these documents are not available on that site as soon as they are available on the SEC’s site.

 

Holdings also makes available on http://www.lehman.com (i) its Corporate Governance Guidelines, (ii) its Code of Ethics (including any waivers therefrom granted to executive officers or directors) and (iii) the charters of the Audit, Compensation and Benefits, and Nominating and Corporate Governance Committees of its Board of Directors. These documents are also available in print without charge to any person who requests them by writing or telephoning:

 

Lehman Brothers Holdings Inc.

Office of the Corporate Secretary

1271 Avenue of the Americas

42nd Floor

New York, New York 10020, U.S.A.

1-212-526-0858

 

In order to view and print the documents referred to above (which are in the .PDF format) on Holdings’ internet site, you will need to have installed on your computer the Adobe® Acrobat® Reader® software. If you do not have Adobe Acrobat, a link to Adobe Systems Incorporated’s internet site, from which you can download the software, is provided.

 

 

- 3 -

 


 

LEHMAN BROTHERS HOLDINGS INC.

PART I—FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Income

(Unaudited)

 

 

 

Three Months Ended May 31,

 

Six Months Ended May 31,

 

In millions, except per share data

 

          2008

 

      2007

 

          2008

 

   2007

 

Revenues

 

 

 

 

 

 

 

 

 

Principal transactions

 

$

(3,442

)

$

2,889

 

$

(2,670

)

$

5,810

 

Investment banking

 

858

 

1,150

 

1,725

 

2,000

 

Commissions

 

639

 

568

 

1,297

 

1,108

 

Interest and dividends

 

7,771

 

10,558

 

17,405

 

19,647

 

Asset management and other

 

414

 

414

 

853

 

809

 

Total revenues

 

6,240

 

15,579

 

18,610

 

29,374

 

Interest expense

 

6,908

 

10,067

 

15,771

 

18,815

 

Net revenues

 

(668

)

5,512

 

2,839

 

10,559

 

Non-Interest Expenses

 

 

 

 

 

 

 

 

 

Compensation and benefits

 

2,325

 

2,718

 

4,166

 

5,206

 

Technology and communications

 

309

 

287

 

612

 

553

 

Brokerage, clearance and distribution fees

 

252

 

201

 

504

 

395

 

Occupancy

 

188

 

152

 

373

 

298

 

Professional fees

 

100

 

120

 

198

 

218

 

Business development

 

87

 

100

 

175

 

184

 

Other

 

158

 

55

 

235

 

127

 

Total non-personnel expenses

 

1,094

 

915

 

2,097

 

1,775

 

Total non-interest expenses

 

3,419

 

3,633

 

6,263

 

6,981

 

Income before taxes

 

(4,087

)

1,879

 

(3,424

)

3,578

 

Provision for income taxes

 

(1,313

)

606

 

(1,139

)

1,159

 

Net income

 

$

(2,774

)

$

1,273

 

$

(2,285

)

$

2,419

 

Net income applicable to common stock

 

$

(2,873

)

$

1,256

 

$

(2,408

)

$

2,385

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(5.14

)

$

2.33

 

$

(4.33

)

$

4.42

 

Diluted

 

$

(5.14

)

$

2.21

 

$

(4.33

)

$

4.17

 

Dividends paid per common share

 

$

0.17

 

$

0.15

 

$

0.34

 

$

0.30

 

 

See Notes to Consolidated Financial Statements.

 

 

- 4 -


 

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Financial Condition

(Unaudited)

 

 

 

At

 

In millions

 

May 31, 2008

 

Nov 30, 2007

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

6,513

 

$

7,286

 

 

 

 

 

 

 

Cash and securities segregated and on deposit for regulatory and other purposes

 

13,031

 

12,743

 

 

 

 

 

 

 

Financial instruments and other inventory positions owned
(includes $
43,031
in 2008 and $63,499 in 2007 pledged as collateral)

 

269,409

 

313,129

 

 

 

 

 

 

 

Collateralized agreements:

 

 

 

 

 

 

 

 

 

 

 

Securities purchased under agreements to resell

 

169,684

 

162,635

 

 

 

 

 

 

 

Securities borrowed

 

124,842

 

138,599

 

 

 

 

 

 

 

Receivables:

 

 

 

 

 

 

 

 

 

 

 

Brokers, dealers and clearing organizations

 

16,701

 

11,005

 

 

 

 

 

 

 

Customers

 

20,784

 

29,622

 

 

 

 

 

 

 

Others

 

4,236

 

2,650

 

 

 

 

 

 

 

Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization of
$
2,697
in 2008 and $2,438 in 2007)

 

4,278

 

3,861

 

 

 

 

 

 

 

Other assets

 

5,853

 

5,406

 

 

 

 

 

 

 

Identifiable intangible assets and goodwill
(net of accumulated amortization of $
361
in 2008 and $340 in 2007)

 

4,101

 

4,127

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

639,432

 

$

691,063

 

 

 

 

 

 

 

 

 

 

See Notes to Consolidated Financial Statements.

 

 

- 5 -


 

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Financial Condition—(Continued)

(Unaudited)

 

 

 

At

 

In millions, except share data

 

May 31, 2008

 

Nov 30, 2007

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Short-term borrowings and current portion of long-term borrowings
(including $9,354 in 2008 and $9,035 in 2007 at fair value)

 

$

35,302

 

$

28,066

 

Financial instruments and other inventory positions sold but not yet purchased

 

141,507

 

149,617

 

Collateralized financings:

 

 

 

 

 

Securities sold under agreements to repurchase

 

127,846

 

181,732

 

Securities loaned

 

55,420

 

53,307

 

Other secured borrowings
(including $13,617 in 2008 and $9,149 in 2007 at fair value)

 

24,656

 

22,992

 

Payables:

 

 

 

 

 

Brokers, dealers and clearing organizations

 

3,835

 

3,101

 

Customers

 

57,251

 

61,206

 

Accrued liabilities and other payables

 

9,802

 

16,039

 

Deposit liabilities at banks
(including $10,252 in 2008 and $15,986 in 2007 at fair value)

 

29,355

 

29,363

 

Long-term borrowings
(including $27,278 in 2008 and $27,204 in 2007 at fair value)

 

128,182

 

123,150

 

Total liabilities

 

613,156

 

668,573

 

Commitments and contingencies

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

Preferred stock

 

6,993

 

1,095

 

Common stock, $0.10 par value:

 

 

 

 

 

Shares authorized: 1,200,000,000 in 2008 and 2007;

 

 

 

 

 

Shares issued: 612,948,910 in 2008 and 612,882,506 in 2007;

 

 

 

 

 

Shares outstanding: 552,704,921 in 2008 and 531,887,419 in 2007

 

61

 

61

 

Additional paid-in capital

 

11,268

 

9,733

 

Accumulated other comprehensive loss, net of tax

 

(359

)

(310

)

Retained earnings

 

16,901

 

19,698

 

Other stockholders’ equity, net

 

(3,666

)

(2,263

)

Common stock in treasury, at cost
(60,243,989 shares in 2008 and 80,995,087 shares in 2007)

 

(4,922

)

(5,524

)

Total common stockholders’ equity

 

19,283

 

21,395

 

Total stockholders’ equity

 

26,276

 

22,490

 

Total liabilities and stockholders’ equity

 

$

639,432

 

$

691,063

 

 

See Notes to Consolidated Financial Statements.

 

 

- 6 -


 

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Cash Flows

(Unaudited)

 

 

 

Six Months Ended May 31,

 

In millions

 

 2008

 

  2007

 

Cash Flows From Operating Activities

 

 

 

 

 

Net income

 

$

(2,285

)

$

2,419

 

Adjustments to reconcile net income to net cash
used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

325

 

284

 

Non-cash compensation

 

868

 

631

 

Other adjustments

 

(59

)

(32

)

Net change in:

 

 

 

 

 

Cash and securities segregated and on deposit
for regulatory and other purposes

 

(288

)

(1,063

)

Financial instruments and other inventory positions owned

 

43,052

 

(56,923

)

Resale agreements, net of repurchase agreements

 

(60,935

)

(9,063

)

Securities borrowed, net of securities loaned

 

15,870

 

(6,492

)

Other secured borrowings

 

1,664

 

7,611

 

Receivables from brokers, dealers and clearing organizations

 

(5,696

)

84

 

Receivables from customers

 

8,838

 

(8,454

)

Financial instruments and other inventory positions sold
but not yet purchased

 

(7,743

)

41,929

 

Payables to brokers, dealers and clearing organizations

 

734

 

281

 

Payables to customers

 

(3,955

)

6,278

 

Accrued liabilities and other payables

 

(6,261

)

1,008

 

Other receivables and assets

 

(2,028

)

(2,313

)

Net cash used in operating activities

 

(17,899

)

(23,815

)

Cash Flows From Investing Activities

 

 

 

 

 

Purchase of property, equipment and leasehold improvements, net

 

(487

)

(447

)

Business acquisitions, net of cash acquired

 

(91

)

(461

)

Proceeds from sale of business

 

 

65

 

Net cash used in investing activities

 

(578

)

(843

)

Cash Flows From Financing Activities

 

 

 

 

 

Net (payments for) proceeds from:

 

 

 

 

 

Issuance of short-term borrowings, net

 

3,046

 

2,684

 

Derivative contracts with a financing element

 

(367

)

126

 

Deposit liabilities at banks

 

(8

)

(598

)

Tax benefit from the issuance of stock-based awards

 

37

 

225

 

Net proceeds from:

 

 

 

 

 

Issuance of common stock

 

2

 

28

 

Issuance of long-term borrowings

 

32,798

 

39,824

 

Issuance of preferred stock, net of issuance cost

 

5,856

 

 

Issuance of treasury stock

 

203

 

240

 

Payments for:

 

 

 

 

 

Principal payments of long-term borrowings, including the
current portion of long term borrowings

 

(22,769

)

(16,315

)

Purchase of treasury stock

 

(760

)

(2,039

)

Dividends paid

 

(334

)

(211

)

Net cash provided by financing activities

 

17,704

 

23,964

 

Net change in cash and cash equivalents

 

(773

)

(694

)

Cash and cash equivalents, beginning of period

 

7,286

 

5,987

 

Cash and cash equivalents, end of period

 

$

6,513

 

$

5,293

 

Supplemental Disclosure of Cash Flow Information (in millions):

 

 

 

 

 

Interest paid totaled $15,194 and $19,102 in 2008 and 2007, respectively.

 

 

 

 

 

Income taxes paid totaled $499 and $886 in 2008 and 2007, respectively.

 

 

 

 

 

 

See Notes to Consolidated Financial Statements.

 

 

- 7 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

 

Contents

 

 

 

 

Page

 

 

Number

 

 

 

Note 1

Summary of Significant Accounting Policies

9

 

 

 

Note 2

Business and Geographic Segments

21

 

 

 

Note 3

Financial Instruments and Other Inventory Positions

24

 

 

 

Note 4

Fair Value of Financial Instruments

27

 

 

 

Note 5

Securities Received and Pledged as Collateral

34

 

 

 

Note 6

Securitizations and Special Purpose Entities

34

 

 

 

Note 7

Borrowings and Deposit Liabilities

38

 

 

 

Note 8

Commitments, Contingencies and Guarantees

39

 

 

 

Note 9

Earnings per Common Share

43

 

 

 

Note 10

Income Taxes

44

 

 

 

Note 11

Employee Benefit Plans

45

 

 

 

Note 12

Regulatory Requirements

45

 

 

 

Note 13

Condensed Consolidating Financial Statement Schedules

46

 

 

 

Note 14

Subsequent Events

52

 

 

- 8 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 1 Summary of Significant Accounting Policies

Description of Business

 

Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company,” the “Firm,” “Lehman Brothers,” “we,” “us” or “our”) serves the financial needs of corporations, governments and municipalities, institutional clients and high net worth individuals worldwide with business activities organized in three segments: Capital Markets, Investment Banking and Investment Management. Founded in 1850, Lehman Brothers maintains market presence in equity and fixed income sales, trading and research, investment banking, asset management, private investment management and private equity. The Firm is headquartered in New York, with regional headquarters in London and Tokyo, and operates in a network of offices in North America, Europe, the Middle East, Latin America and the Asia-Pacific region. The Company is a member of all principal securities and commodities exchanges in the U.S., and holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Milan and Australian stock exchanges.

 

Basis of Presentation

 

The Consolidated Financial Statements are prepared in conformity with U.S. generally accepted accounting principles and include the accounts of Holdings, its subsidiaries, and all other entities in which the Company has a controlling financial interest or are considered to be the primary beneficiary. In the opinion of management, all normal recurring adjustments have been included for a fair statement of this interim financial information. All material inter-company accounts and transactions have been eliminated upon consolidation. Certain prior-period amounts reflect reclassifications to conform to the current year’s presentation.

 

Use of Estimates

 

In preparing the Consolidated Financial Statements and accompanying notes, management makes various estimates that affect reported amounts and disclosures. Broadly, those estimates are used in:

 

·      measuring fair value of certain financial instruments;

 

·      accounting for identifiable intangible assets and goodwill;

 

·      establishing provisions for potential losses that may arise from litigation, regulatory proceedings and tax examinations;

 

·      assessing the Company’s ability to realize deferred taxes; and

 

·      valuing equity-based compensation awards.

 

Estimates are based on available information and judgment. Therefore, actual results could differ from estimates and that difference could have a material effect on the Consolidated Financial Statements and notes thereto.

 

Consolidation Policies

 

The Consolidated Financial Statements include the accounts of Holdings and the entities in which the Company has a controlling financial interest. The Company determines whether it has a controlling financial interest in an entity by first determining whether the entity is a voting interest entity (sometimes referred to as a non-VIE), a variable interest entity (“VIE”) or a qualified special purpose entity (“QSPE”).

 

Voting Interest Entity. Voting interest entities are entities that have (i) total equity investment at risk sufficient to fund expected future operations independently; and (ii) equity holders who have the obligation to absorb losses or receive residual returns and the right to make decisions about the entity’s activities. In accordance with Accounting Research Bulletin (“ARB”) No. 51, Consolidated Financial Statements, and Statement of Financial Accounting Standards (“SFAS”) No. 94, Consolidation of All Majority—Owned Subsidiaries )(“SFAS 94”), voting interest entities are consolidated when the Company has a controlling financial interest, typically more than 50% of an entity’s voting interests.

 

Variable Interest Entity. VIEs are entities that lack one or more voting interest entity characteristics. The Company consolidates VIEs in which it is the primary beneficiary. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 46, Consolidation of Variable Interest Entities (revised December 2003)—an interpretation of ARB No. 51 (“FIN 46(R)”), the Company is the primary beneficiary if it has a variable interest, or a combination of variable interests, that will either (i) absorb a majority of the VIE’s expected losses; (ii) receive a majority of the VIE’s expected residual returns; or (iii) both. To determine if the Company is the primary beneficiary of a VIE, the Company reviews,

 

 

- 9 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

among other factors, the VIE’s design, capital structure, contractual terms, which interests create or absorb variability and related party relationships, if any. Additionally, the Company may calculate its share of the VIE’s expected losses and expected residual returns based upon the VIE’s contractual arrangements and/or position in the VIE’s capital structure. This type of analysis is typically performed using expected cash flows allocated to the expected losses and expected residual returns under various probability-weighted scenarios.

 

Qualified Special Purpose Entity. QSPEs are passive entities with limited permitted activities. SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125 (“SFAS 140”), establishes the criteria an entity must satisfy to be a QSPE, including types of assets held, limits on asset sales, use of derivatives and financial guarantees, and discretion exercised in servicing activities. In accordance with SFAS 140 and FIN 46(R), the Company does not consolidate QSPEs.

 

For a further discussion of the Company’s involvement with VIEs, QSPEs and other entities, see Note 6, “Securitizations and Special Purpose Entities,” to the Consolidated Financial Statements. For a further discussion regarding potential changes to consolidation-related accounting standards, see “Accounting and Regulatory Developments—Elimination of QSPEs and Changes in the FIN 46(R) Consolidation Model” below.

 

Equity-Method Investments. Entities in which the Company does not have a controlling financial interest (i.e., non-consolidated entities) but in which the Company exerts significant influence (generally defined as owning a voting interest of 20% to 50%, or a partnership interest greater than 3%) are accounted for either under Accounting Principles Board (“APB”) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock or SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). For further discussion of the Company’s adoption of SFAS 159, see “Accounting and Regulatory Developments—SFAS 159” below.

 

Other. The Company has formed various non-consolidated private equity or other alternative investment funds with third-party investors that are typically organized as limited partnerships. The Company typically acts as general partner for these funds, and when third-party investors have (i) rights to either remove the general partner without cause or to liquidate the partnership; or (ii) substantive participation rights, the Company does not consolidate these partnerships in accordance with Emerging Issue Task Force (“EITF”) No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights.

 

A determination of whether the Company has a controlling financial interest in an entity and therefore a consolidation assessment of that entity is initially made at the time the Company becomes involved with the entity. Certain events may occur which cause the Company to re-assess its initial determination of an entity. These re-assessments focus on whether an entity is a VIE or non-VIE, whether the Company is the primary beneficiary (if the entity is a VIE) and ultimately its consolidation assessment of that entity. Those events generally are:

 

·      The entity’s governance structure is changed such that either (i) the characteristics or adequacy of equity at risk are changed, or (ii) expected returns or losses are reallocated among the participating parties within the entity.

 

·      The equity investment (or some part thereof) is returned to the equity investors and other interests become exposed to expected returns or losses.

 

·      Additional activities are undertaken or assets acquired by the entity that were beyond those anticipated previously.

 

·      Participants in the entity acquire or sell interests in the entity.

 

·      The entity receives additional equity at risk or curtails its activities in a way that changes the expected returns or losses.

 

When the Company does not consolidate an entity or apply the equity method of accounting, the Company presents its investment in the entity at fair value.

 

 

- 10 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Currency Translation

 

Assets and liabilities of subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the applicable Consolidated Statement of Financial Condition date. Revenues and expenses are translated at average exchange rates during the period. The gains or losses resulting from translating non-U.S. dollar functional currency into U.S. dollars, net of hedging gains or losses, are included in Accumulated other comprehensive income/(loss), net of tax, a component of Stockholders’ equity. Gains or losses resulting from non-U.S. dollar currency transactions are included in the Consolidated Statement of Income.

 

Revenue Recognition Policies

 

Principal transactions. Realized and unrealized gains or losses from Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased, as well as the gains or losses from certain short- and long-term borrowing obligations, principally certain hybrid financial instruments, and certain deposit liabilities at banks that the Company measures at fair value are reflected in Principal transactions in the Consolidated Statement of Income.

 

Investment banking. Underwriting revenues, net of related underwriting expenses, and revenues for merger and acquisition advisory and other investment banking-related services are recognized when services for the transactions are completed. In instances where the Investment Banking segment provides structuring services and/or advice in a capital markets-related transaction, the Company records a portion of the transaction-related revenue as Investment Banking fee revenues.

 

Commissions. Commissions primarily include fees from executing and clearing client transactions on equities, options and futures markets worldwide. These fees are recognized on a trade-date basis.

 

Interest and dividends revenue and interest expense. The Company recognizes contractual interest on Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased, excluding derivatives, on an accrual basis as a component of Interest and dividends revenue and Interest expense, respectively. The Company accounts for its secured financing activities and certain short- and long-term borrowings on an accrual basis with related interest recorded as interest revenue or interest expense, as applicable. Contractual interest expenses on all deposit liabilities and certain hybrid financial instruments are recorded as components of Interest expense.

 

Asset management and other. Investment advisory fees are recorded as earned. In certain circumstances, the Company receives asset management incentive fees based upon fund performance. Incentive fees are generally based on investment performance over a twelve-month period and are not subject to adjustment after the measurement period ends. Accordingly, the Company recognizes incentive fees when the measurement period ends.

 

The Company also receives private equity incentive fees when the returns on certain private equity or other alternative investment funds’ investments exceed specified thresholds. Private equity incentive fees typically are based on investment results over a period greater than one year. If the funds underperform in the future, previously distributed fees could be required to be returned. Accordingly, the Company recognizes these incentive fees when all material contingencies have been substantially resolved.

 

Income Taxes

 

The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. The Company recognizes the current and deferred tax consequences of all transactions that have been recognized in the Consolidated Financial Statements using the provisions of the enacted tax laws. Deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carry-forwards. The Company records a valuation allowance to reduce deferred tax assets to an amount that more likely than not will be realized. Deferred tax liabilities are recognized for temporary differences that will result in taxable income in the future.

 

The Company recognizes and measures its unrecognized tax benefits in accordance with FIN 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109 (“FIN 48”). Based on their technical merits, the Company estimates the likelihood, that tax positions will be sustained upon examination based on the facts, circumstances and information available at the end of each period. The Company adjusts the level of unrecognized tax benefits when there is more information available, or when an event occurs requiring a change. The reassessment of unrecognized tax benefits could have a material impact on the Company’s effective tax rate in the period in which it occurs. For a discussion of the impact of FIN 48, see “Accounting and Regulatory Developments—FIN 48” below.

 

 

- 11 -

 


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Earnings per Share

 

The Company computes earnings per share (“EPS”) in accordance with SFAS No. 128, Earnings per Share. Basic EPS is computed by dividing net income applicable to common stock by the weighted-average number of common shares outstanding, which includes restricted stock units (“RSUs”) for which service has been provided. Diluted EPS includes the components of basic EPS and also includes the dilutive effects of RSUs for which service has not yet been provided and employee stock options.

 

Financial Instruments and Other Inventory Positions

 

Substantially all of the Company’s Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased are reported at fair value. The Company accounts for these assets and liabilities at fair value under various accounting literature and applicable industry guidance, namely broker-dealer and investment company accounting guidance. The Company categorizes Real estate held for sale positions as a component of Financial instruments and other inventory positions owned. Real estate held for sale positions are reported by the Company at the lower of carrying amount or fair value less cost to sell.

 

The Company early adopted the provisions of SFAS No. 157, Fair Value Measurements (“SFAS 157”), in the first quarter of 2007. SFAS 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements. Prior to December 1, 2006, the Company followed the American Institute of Certified Public Accountants (“AICPA”) Audit and Accounting Guide, Brokers and Dealers in Securities, when determining fair value for financial instruments. The AICPA Audit and Accounting Guide permitted the recognition of a discount to the quoted price when determining the fair value for a substantial block of a particular security as long as the quoted price was not considered to be readily realizable (i.e., a block discount).

 

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, or an “exit” price. Generally, assets (long positions) are marked to bid prices and liabilities (short positions) are marked to offer prices. Neither the bid nor the offer prices are adjusted for transactional costs. Fair value differs from cost accounting in that cost accounting would value financial instruments at their acquisition price—not at their value if currently sold in the market, or fair value.

 

When observable prices are not available, the Company either uses implied pricing from similar instruments or valuation models based on net present value of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors. New and/or complex instruments may have immature or limited markets. As a result, the pricing models used by the Company for valuation may incorporate significant estimates and assumptions that market participants would use in pricing the instrument. For instance, the Company may apply extrapolation methods for long-dated and illiquid contracts where observed market data is utilized in order to estimate inputs and assumptions that are not directly observable. Assumptions used by the Company in valuation models may impact the results of operations reported in the Consolidated Financial Statements. As the markets for products develop, the Company continually refines its pricing models to correlate more closely to the market price of the instruments.

 

Derivative Contracts. A derivative is a financial instrument whose value is based on an underlying asset (e.g., Treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). Derivative financial instruments include futures, forwards, swaps, option contracts or other financial instruments with similar characteristics. A derivative contract generally represents a future commitment to exchange interest payment streams or currencies based on the contract terms, or notional amount, (e.g., interest rate swaps or currency forwards) or to purchase or sell financial instruments at specified terms or dates (e.g., option to buy or sell securities). An exchange traded derivative is a standardized contract transacted through regulated exchanges and includes futures and certain option contracts that are listed on an exchange. An over-the-counter (“OTC”) derivative financial instrument is a privately negotiated contractual agreement that may include forward, swaps and certain options.

 

Derivative contracts held by the Company are presented as a component of Financial instruments and other inventory positions owned or Financial instruments and other inventory positions sold but not yet purchased in the Consolidated Statement of Financial Condition. Derivatives are presented net-by-counterparty when the Company believes legal right of offset exists; net across different products or positions when applicable provisions are stated in a master netting agreement; and/or net of cash collateral received or paid on a counterparty basis, provided legal right of offset exists. As a component of the Company’s Financial instruments and other inventory positions owned or Financial instruments and other inventory positions sold but not yet purchased in the Consolidated Statement of Financial Condition, derivatives are presented at fair value. The fair value for OTC derivative financial instruments (forwards, options and swaps) is calculated as the present value of the estimated future

 

 

- 12 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

payments the Company would receive or remit from or to a market participant in settlement of the OTC derivative instrument (i.e., the amount the Company would expect to receive when disposing of a derivative asset or would expect to pay to have a derivative liability assumed).

 

Prior to the Company’s adoption of SFAS 157, the Company followed EITF Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF 02-3”). Under EITF 02-3, recognition of a trading profit at inception of a derivative transaction was prohibited unless the fair value of that derivative was obtained from a quoted market price supported by comparison to other observable inputs or based on a valuation technique incorporating observable inputs. Subsequent to the inception date (“Day 1”), the Company recognized trading profits deferred at Day 1 in the period in which the valuation of the instrument became observable. The adoption of SFAS 157 nullified the guidance in EITF 02-3 that precluded the recognition of a trading profit at the inception of a derivative contract, unless the fair value of such derivative was obtained from a quoted market price or other valuation technique incorporating observable inputs.

 

The Company enters into derivative contracts for trading purposes and as an end user. In instances where the Company enters into derivatives in a trading capacity, it is to facilitate a client transaction, execute a proprietary trading strategy or economically hedge market or credit risk exposures incurred as a result of other trading activities. For these trading-related derivatives, margins on futures contracts are included in Receivables and Payables from/to brokers, dealers and clearing organizations, as applicable.

 

Derivative contracts into which the Company enters as an end-user are primarily designed to economically hedge the Company’s exposure to market risk and/or credit risk. These end-user derivative contracts generally:

 

·                Attempt to achieve efficient financing costs on the Company’s borrowing and deposit liabilities by converting the underlying interest rate basis or variability of payments.

 

·                Mitigate the impact to the Company of changes in exchange rates that may impact the Company’s investment in foreign operations and/or financial instruments in inventory denominated in non-U.S. currencies.

 

·                Manage price risk or the change in fair value of an asset or liability. These economic hedges may be micro (on specific inventory positions or specific trading books) or macro (generally intended to mitigate the overall risks present in the businesses in which the Company operates). The Company may enter into a derivative contract whose value is based upon a specific financial instrument class, an index that references that financial instrument class or a rate that impacts the financial instrument’s value. The Company’s position in that contract is typically designed such that it mitigates changes in the fair value of the instrument.

 

In instances where the Company specifically designates a derivative position as a hedge, the Company accounts for the position under the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). The Company assesses, both at the inception of the hedge and on an ongoing basis, whether the derivative contract designated as an accounting hedge is effective. When the Company determines that a derivative contract is not effective as an accounting hedge, the Company discontinues hedge accounting.

 

Certain of the derivative contracts entered into by the Company qualify as accounting hedges under the guidance of SFAS 133. The following generally summarizes those contracts as well as the assessment made for effectiveness:

 

·                  Derivative contracts that are designated as an interest rate hedge (including hedges on foreign currency movements) because they are intended to hedge the variability of interest rates to be received or paid related to the recognized assets or liabilities. Changes in the fair value of derivatives that are designated and qualify as accounting hedges of interest rate risk, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk are recorded within Interest revenue or expense. At inception of an accounting hedge risk and on an ongoing basis, the Company assesses effectiveness on a prospective basis by comparing the expected change in the price of the hedge instrument to the expected change in the value of the hedged item under various interest rate assumptions. Effectiveness is also assessed on a retrospective basis by performing regression analyses. Ineffectiveness for derivative contracts that the Company designated as interest rate hedges were immaterial for all periods presented.

 

·                  Derivative contracts that are designated as a cash flow hedge because they intend to hedge the variability of cash flows to be received or paid related to an asset or liability. Changes in the fair value of derivatives that are designated and qualify as effective cash flow hedges are recorded in Accumulated other comprehensive income/(loss), net of tax, in Stockholders’ equity. At inception of an accounting hedge and on an ongoing basis., the Company assesses effectiveness on a prospective basis by comparing the present value of the projected cash

 

 

- 13 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

flows on the derivative contract to the present value of the projected cash flows of the hedged item under various interest rate and prepayment assumptions. Effectiveness is also assessed on a retrospective basis by performing regression analyses. Ineffectiveness for derivative contracts that the Company designated as cash flow hedges were immaterial for all periods presented.

 

The Fair Value Hierarchy. While SFAS 157 does not prescribe which valuation technique the Company should use to measure the fair value of an asset or a liability, SFAS 157 does require the Company to select an appropriate valuation technique for the market conditions and for which sufficient, reliable data inputs are available. SFAS 157 distinguishes between inputs that are based on market data obtained from independent sources and inputs that reflect assumptions from one market participant as to actions of other market participants and emphasizes that valuation methodologies maximize inputs based on market data. A determination of what constitutes “observable market data” requires significant judgment. The Company considers observable or market-based data to be data that can be characterized as not proprietary, readily available or based on consensus within reasonably narrow ranges, regularly distributed or updated, reliable and verifiable and provided by multiple, independent sources that are involved in the relevant market.

 

Inputs to valuation techniques used by the Company to determine the fair value of an asset or a liability are prioritized based upon the SFAS 157 hierarchy. The SFAS 157 hierarchy gives priority to observable inputs in the marketplace that are more objective, rather than inputs that are more subjective because they have been derived through extrapolation or interpolation from market data. The basis of a financial instrument level within the fair value hierarchy is the lowest level of any input that is significant to the fair value measurement. The categorization of an asset or liability within the SFAS 157 hierarchy is based upon the pricing transparency of the financial instrument and does not necessarily correspond to the perceived risk of the asset or liability. The following describes the three levels of the fair value hierarchy under SFAS 157, provides general characteristics and examples of measurement inputs associated with each hierarchical level as well as valuation techniques used by the Company for components of its financial instrument inventory.

 

Level 1 — Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market (e.g., an equity security traded on the New York Stock Exchange) provides the most reliable fair value measurement because it is directly observable to the market. The types of assets and liabilities valued based on quoted market prices in active markets and categorized by the Company as Level 1 within the fair value hierarchy generally include equities listed in active markets, G-7 government and agency securities, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

 

Level 2 — Level 2 inputs are inputs that are observable, either directly or indirectly, but do not qualify as Level 1 inputs. Level 2 inputs may include:

 

·                  Quoted prices for similar assets or liabilities in active markets

 

·                 Quoted prices for identical or similar assets or liabilities in markets that are not active, that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers (e.g., some brokered markets), or in which little information is released publicly (e.g., a principal-to-principal market)

 

·                 Inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates)

 

·                 Inputs that are derived principally from or corroborated by observable market data through correlation or by other means (market-corroborated inputs)

 

The types of assets and liabilities that trade in markets that are not considered to be active, but are valued based on quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include non-G-7 government securities, municipal bonds, certain hybrid financial instruments, certain mortgage and asset backed securities, certain corporate debt, certain commitments and guarantees, certain private equity investments, including equity interests in investment managers, and certain derivatives. Level 2 derivatives are valued using pricing models based on the net present value of estimated future cash flows and directly observed prices from exchange-traded derivatives, other OTC derivative contracts, or external pricing services, while taking into account either the Company’s or counterparty’s creditworthiness, as appropriate. Determining the fair value for Level 2 derivative contracts can require a significant level of estimation and management judgment.

 

 

- 14 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Financial instruments categorized as Level 2 within the SFAS 157 hierarchy are generally presented, at inception, using the transacted price. Thereafter, the Company generally values Level 2 assets and liabilities based upon comparable market prices or other relevant information from market transactions involving identical or comparable assets and liabilities.

 

Level 3 — Level 3 inputs reflect the Company’s assumptions that it believes market participants would use in pricing the asset or liability. The Company develops Level 3 inputs based on the best information available in the circumstances, which may include indirect correlation to a market value, combinations of market values or the Company’s proprietary data. Level 3 inputs generally include information derived through extrapolation or interpolation of observable market data.

 

At May 31, 2008, the Company included within Level 3 certain assets and liabilities that were components of the following inventory classifications:

 

·                 Certain Mortgage and asset-backed securities which, at inception, may be reflected at the original transaction cost. However, they subsequently may be reflected at a value based upon valuation methodologies that incorporate a variety of inputs including prices observed from execution of a number of trades in the marketplace; ABX, CMBX and similar indices that track the performance of a series of credit default swaps based upon specific types of mortgages; and other market information, such as data on remittances received and updated cumulative loss data on underlying obligations. These asset types include mortgage whole loans, asset-backed securities, and private label or agency collateralized mortgage obligations.

 

·                 Certain corporate debt positions which generally are initially presented at the original transaction price. Thereafter, the fair value of these positions are generally estimated by using executed transactions on comparable positions and anticipated market prices based upon pricing indications from syndicate banks and customers. The valuation of these positions also takes into account certain fee income, third-party credit ratings of counterparties and underlying movements in credit spreads of the counterparties. These asset types include non-performing loan portfolios, loans to counterparties that do not have correlation to market prices, and other loans held and awaiting securitization or syndication.

 

·                 Certain corporate equities, generally unlisted or private placement positions, which generally are originally reflected at their transaction price. Thereafter, these positions are subsequently valued based on third-party investments, pending transactions or changes in financial ratios (e.g., earnings multiples). These asset types include private equity and principal investment positions in addition to equity interests in corporations or investment vehicles.

 

·                 Derivative positions that were originally recorded based upon valuation models using initial trade prices. Changes in the valuations thereafter are not a result of changes in model methodology but changes in model inputs (e.g., interest rates, credit spreads and volatilities). Model inputs are updated only when those inputs can be corroborated with other market data. These asset types include interest rate option contracts, credit default swaptions, structured volatility derivatives and other forward starting contracts that are generally long-tenured.

 

For further discussion of the adoption of SFAS 157, see “Accounting and Regulatory Developments—SFAS 157” below. For further discussion of Financial instruments and other inventory positions, see Note 3, “Financial Instruments and Other Inventory Positions,” to the Consolidated Financial Statements. Firm-owned securities pledged to counterparties who have the right, by contract or custom, to sell or repledge the securities are classified as Financial instruments and other inventory positions owned and are disclosed as pledged as collateral. For further discussion of securities received and pledged as collateral, see Note 5, “Securities Received and Pledged as Collateral,” to the Consolidated Financial Statements.

 

Securitization activities. In accordance with SFAS 140, the Company recognizes transfers of financial assets as sales, if control has been surrendered. The Company determines control has been surrendered when the following three criteria have been met:

 

·                  The transferred assets have been isolated from the transferor, or put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (i.e., a true sale opinion has been obtained);

 

 

- 15 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

·                 Each transferee (or, if the transferee is a QSPE, each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor; and

 

·                 The transferor does not maintain effective control over the transferred assets through either (i) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (ii) the ability to unilaterally cause the holder to return specific assets.

 

Collateralized Lending Agreements and Financings

 

Treated as collateralized agreements and financings for financial reporting purposes are the following:

 

·                Repurchase and resale agreements. Securities purchased under agreements to resell and securities sold under agreements to repurchase are collateralized primarily by government and government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities subsequently will be resold or repurchased plus accrued interest. The Company takes possession of securities purchased under agreements to resell. The fair value of the underlying positions is compared daily with the related receivable or payable balances, including accrued interest. The Company requires counterparties to deposit additional collateral or return collateral pledged, as necessary, to ensure the fair value of the underlying collateral remains sufficient.

 

·                Securities borrowed and securities loaned. Securities borrowed and securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. The Company values the securities borrowed and loaned daily and obtains additional cash as necessary to ensure these transactions are adequately collateralized. When the Company acts as the lender of securities in a securities-lending agreement and the Company receives securities that can be pledged or sold as collateral, the Company recognizes an asset, representing the securities received and a liability, representing the obligation to return those securities.

 

·                Other secured borrowings. Other secured borrowings principally reflect transfers accounted for as financings rather than sales under SFAS 140. Additionally, Other secured borrowings includes non-recourse financings of entities that the Company has consolidated because the Company is the primary beneficiary of such entities.

 

Long-Lived Assets

 

Property, equipment and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets. Buildings are depreciated up to a maximum of 40 years. Leasehold improvements are amortized over the lesser of their useful lives or the terms of the underlying leases, which range up to 30 years. Equipment, furniture and fixtures are depreciated over periods of up to 10 years. Internal-use software that qualifies for capitalization under AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, is capitalized and subsequently amortized over the estimated useful life of the software, generally three years, with a maximum of seven years. The Company reviews long-lived assets for impairment periodically and whenever events or changes in circumstances indicate the carrying amounts of the assets may be impaired. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized to the extent the carrying value of the asset exceeds its fair value.

 

Identifiable Intangible Assets and Goodwill

 

Identifiable intangible assets with finite lives are amortized over their expected useful lives, which range up to 15 years. Identifiable intangible assets with indefinite lives and goodwill are not amortized. Instead, these assets are evaluated at least annually for impairment. Goodwill is reduced upon the recognition of certain acquired net operating loss carryforward benefits.

 

Cash Equivalents

 

Cash equivalents include highly liquid investments not held for resale with maturities of three months or less when the Company acquires them.

 

Accounting and Regulatory Developments

 

The following summarizes accounting standards that have been issued during the periods covered by the Consolidated Financial Statements and the effect of adoption on results of operations, if any, actual or estimated.

 

 

- 16 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

SFAS 157. In September 2006, the FASB issued SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value, outlines a fair value hierarchy based on inputs used to measure fair value and enhances disclosure requirements for fair value measurements. SFAS 157 does not change existing guidance as to whether or not an instrument is carried at fair value.

 

SFAS 157 also (i) nullifies the guidance in EITF 02-3 that precluded the recognition of a trading profit at the inception of a derivative contract, unless the fair value of such derivative was obtained from a quoted market price or other valuation technique incorporating observable inputs; (ii) clarifies that an issuer’s credit standing should be considered when measuring liabilities at fair value; (iii) precludes the use of a liquidity or block discount when measuring instruments traded in an active market at fair value; and (iv) requires costs related to acquiring financial instruments carried at fair value to be included in earnings as incurred.

 

The Company elected to early adopt SFAS 157 at the beginning of the 2007 fiscal year and recorded the difference between the carrying amounts and fair values of (i) stand-alone derivatives and/or certain hybrid financial instruments measured using the guidance in EITF 02-3 on recognition of a trading profit at the inception of a derivative; and (ii) financial instruments that are traded in active markets that were measured at fair value using block discounts, as a cumulative-effect adjustment to opening retained earnings. As a result of adopting SFAS 157, the Company recognized a $45 million after-tax ($78 million pre-tax) increase to opening retained earnings. For additional information regarding the Company’s adoption of SFAS 157, see Note 4, “Fair Value of Financial Instruments,” to the Consolidated Financial Statements.

 

SFAS 158. In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Retirement Plans (“SFAS 158”), which requires an employer to recognize the over- or under-funded status of its defined benefit postretirement plans as an asset or liability in its Consolidated Statement of Financial Condition, measured as the difference between the fair value of the plan assets and the benefit obligation. For pension plans, the benefit obligation is the projected benefit obligation; while for other postretirement plans the benefit obligation is the accumulated postretirement obligation. Upon adoption, SFAS 158 requires an employer to recognize previously unrecognized actuarial gains and losses and prior service costs within Accumulated other comprehensive income/(loss), net of tax, a component of Stockholders’ equity. In accordance with the guidance in SFAS 158, the Company adopted this provision of the standard for the year ended November 30, 2007. The adoption of SFAS 158 reduced Accumulated other comprehensive loss by $210 million after-tax ($344 million pre-tax) at November 30, 2007.

 

SFAS 159. In February 2007, the FASB issued SFAS 159 which permits certain financial assets and financial liabilities to be measured at fair value, using an instrument-by-instrument election. The initial effect of adopting SFAS 159 must be accounted for as a cumulative-effect adjustment to opening retained earnings for the fiscal year in which the Company applies SFAS 159. Retrospective application of SFAS 159 to fiscal years preceding the effective date is not permitted.

 

The Company elected to early adopt SFAS 159 beginning in the 2007 fiscal year and to measure at fair value substantially all hybrid financial instruments not previously accounted for at fair value under SFAS No. 155, Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140, as well as certain deposit liabilities at the Company’s U.S. banking subsidiaries. The Company elected to adopt SFAS 159 for these instruments to reduce the complexity of accounting for these instruments under SFAS 133. As a result of adopting SFAS 159, the Company recognized a $22 million after-tax increase ($35 million pre-tax) to opening retained earnings as of December 1, 2006, representing the effect of changing the measurement basis of these financial instruments from an adjusted amortized cost basis at November 30, 2006 to fair value. For additional information regarding the adoption of SFAS 159, see Note 4, “Fair Value of Financial Instruments,” to the Consolidated Financial Statements.

 

SFAS 141(R). In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS 141(R)”). SFAS 141(R) expands the definition of transactions and events that qualify as business combinations; requires that the acquired assets and liabilities, including contingencies, be recorded at the fair value determined on the acquisition date and changes thereafter reflected in revenue, not goodwill; changes the recognition timing for restructuring costs; and requires acquisition costs to be expensed as incurred. Adoption of SFAS 141(R) is required for combinations after December 15, 2008. Early adoption and retroactive application of SFAS 141(R) to fiscal years preceding the effective date are not permitted. The Company is evaluating the impact of adoption on its Consolidated Financial Statements.

 

SFAS 160. In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interest in Consolidated Financial Statements (“SFAS 160”). SFAS 160 re-characterizes minority interests in consolidated subsidiaries as non-controlling interests and requires the classification of minority interests as a component of equity. Under SFAS 160, a change in control will be measured at fair value, with any gain or loss recognized in earnings. The effective date for SFAS 160 is for annual periods beginning on or after December 15, 2008. Early adoption and retroactive application of SFAS 160 to fiscal years

 

 

- 17 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

preceding the effective date are not permitted. The Company is evaluating the impact of adoption on its Consolidated Financial Statements.

 

SFAS 161. In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”). SFAS 161 requires specific disclosures regarding the location and amounts of derivative instruments in the Company’s financial statements; how derivative instruments and related hedged items are accounted for; and how derivative instruments and related hedged items affect the Company’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued and for fiscal years and interim periods after November 15, 2008. Early application is permitted. Because SFAS 161 impacts the Company’s disclosure and not its accounting treatment for derivative instruments and related hedged items, the Company’s adoption of SFAS 161 will not impact the Consolidated Financial Statements.

 

SFAS 162. In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”). SFAS 162 identifies a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles for nongovernmental entities (the “Hierarchy”). The Hierarchy within SFAS 162 is consistent with that previously defined in the AICPA Statement on Auditing Standards No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles (“SAS 69”). SFAS 162 is effective 60 days following the United States Securities and Exchange Commission’s (the “SEC”) approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The adoption of SFAS 162 will not have a material effect on the Consolidated Financial Statements because the Company has utilized the guidance within SAS 69.

 

SFAS 163. In May 2008, the FASB issued SFAS No. 163, Accounting for Financial Guarantee Insurance Contracts—an interpretation of FASB Statement No. 60 (“SFAS 163”). SFAS 163 requires recognition of an insurance claim liability prior to an event of default when there is evidence that credit deterioration has occurred in an insured financial obligation. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years. Early application is not permitted. The Company’s adoption of SFAS 163 will not have a material effect on the Consolidated Financial Statements.

 

FIN 48. In June 2006, the FASB issued FIN 48. FIN 48 sets out a framework for management to use to determine the appropriate level of tax reserves to maintain for uncertain tax positions. FIN 48 uses a two-step approach wherein a tax benefit is recognized if a position is more likely than not to be sustained, and the amount of benefit is then measured on a probabilistic approach, as defined in FIN 48. FIN 48 also sets out disclosure requirements to enhance transparency of an entity’s tax reserves. The Company adopted FIN 48 at the beginning of the 2008 fiscal year and recognized a decrease to opening retained earnings of approximately $178 million. For additional information regarding the adoption of FIN 48, see Note 10, “Income Taxes,” to the Consolidated Financial Statements.

 

SOP 07-1. In June 2007, the AICPA issued Statement of Position (“SOP”) No. 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“SOP 07-1”). SOP 07-1 addresses when the accounting principles of the AICPA Audit and Accounting Guide Investment Companies must be applied by an entity and whether those accounting principles must be retained by a parent company in consolidation or by an investor in the application of the equity method of accounting. The effective date for SOP 07-1 was initially for fiscal years beginning on or after December 15, 2007; however, in February 2008, the FASB directed the FASB Staff to issue SOP 07-1-1 Effective Date of AICPA Statement of Position 07-1,  which indefinitely delays the effective dates for SOP 07-1 and FASB Staff Position (“FSP”) FIN 46(R)-7, Application of FASB Interpretation No. 46(R) to Investment Companies which was effective upon adoption of SOP 07-1.

 

EITF Issue 07-4. In March 2008, the FASB ratified the consensus reached in EITF 07-4, Application of the Two-Class Method under FASB Statement No. 128 to Master Limited Partnerships (“EITF 07-4”). This issue relates to the application of the two-class method under SFAS No. 128, Earnings Per Share, to master limited partnerships (“MLPs”). EITF 07-4 applies to MLPs that are required to make incentive distributions when certain thresholds have been met and that are accounted for as equity distributions. EITF 07-4 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Earlier application is not permitted. Adoption of EITF Issue 07-4 will not have a material effect on the Consolidated Financial Statements.

 

EITF Issue 07-6. In December, 2007, the FASB ratified the consensus reached in EITF 07-6, Accounting for the Sale of Real Estate Subject to the Requirements of FASB Statement No. 66, When the Agreement Includes a Buy-Sell Clause (“EITF 07-6”). This issue relates to accounting for the sale of real estate subject to the requirements of SFAS No. 66, Accounting for Sales of Real Estate. The Task Force reached a conclusion that the selling investor of

 

 

- 18 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

real estate should determine whether a buy-sell clause constitutes an option or other form of prohibited continuing involvement by considering facts and circumstances such as those that might effectively compel the buyer to sell its interest and those that might effectively compel the selling investor to reacquire the real estate, such as negative tax implications, favorable arrangements with the venture, or strategic needs to own the property. EITF 07-6 is effective prospectively and for new arrangements entered into, and assessments performed, in fiscal years beginning after December 5, 2007, and interim periods within those fiscal years. Early application is not permitted. Adoption of EITF 07-6 will not have a material effect on the Consolidated Financial Statements.

 

FSP FAS 140-3. In February 2008, the FASB directed the FASB Staff to issue FSP No. FAS 140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions (“FSP FAS 140-3”). Under FSP FAS 140-3, it is presumed that an initial transfer of a financial asset and a repurchase entered into contemporaneously or in contemplation of each other are considered part of the same arrangement, known as a linked transaction. However, if certain criteria are met, the initial transfer and repurchase financing are not evaluated as a linked transaction and must be evaluated separately under FAS 140. FSP FAS 140-3 will be effective for financial statements issued for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. Earlier application is not permitted. The Company is evaluating the impact of adopting FSP FAS 140-3 on the Consolidated Financial Statements.

 

FSP FAS 142-3. In April 2008, the FASB directed the FASB Staff to issue FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing a renewal or extension assumptions used for purposes of determining the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets (“SFAS 142”).  FSP FAS 142-3 is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141(R) and other U.S. generally accepted accounting principles.  FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008. Earlier application is not permitted. The Company believes the impact of adopting FSP FAS 142-3 will not have a material effect on the Consolidated Financial Statements.

 

FSP FIN 39-1. In April 2007, the FASB directed the FASB Staff to issue FSP No. FIN 39-1, Amendment of FASB Interpretation No. 39 (“FSP FIN 39-1”). FSP FIN 39-1 modifies FIN No. 39, Offsetting of Amounts Related to Certain Contracts, and permits companies to offset cash collateral receivables or payables with net derivative positions under certain circumstances. FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. FSP FIN 39-1 does not affect the Consolidated Financial Statements because it clarified the acceptability of existing market practice, which the Company uses, of netting cash collateral against net derivative assets and liabilities.

 

FSP FIN 48-1. In May 2007, the FASB directed the FASB Staff to issue FSP No. FIN 48-1, Definition of “Settlement” In FASB Interpretation No. 48 (“FSP FIN 48-1”). Under FSP FIN 48-1, a previously unrecognized tax benefit may be subsequently recognized if the tax position is effectively settled and other specified criteria are met. The Company adopted FSP FIN 48-1 upon adoption of FIN 48.

 

FSP APB 14-1. In May 2008, the FASB directed the FASB Staff to issue FSP APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) (“FSP APB 14-1”). FSP APB 14-1 applies to convertible debt instruments that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement of the conversion option. FSP APB 14-1 requires bifurcation of the instrument into a debt component that is initially recorded at fair value and an equity component. The difference between the fair value of the debt component and the initial proceeds from issuance of the instrument is recorded as a component of equity. The liability component of the debt instrument is accreted to par using the effective yield method; accretion is reported as a component of interest expense. The equity component is not subsequently re-valued as long as it continues to qualify for equity treatment. FSP APB 14-1 is effective for financial statements issued and for fiscal years and interim periods after December 15, 2008. Early adoption is not permitted. The Company is evaluating the impact of adopting FSP APB 14-1 on the Consolidated Financial Statements.

 

SAB 109. In November 2007, the SEC issued Staff Accounting Bulletin (“SAB”) No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings (“SAB 109”). SAB 109 supersedes SAB No. 105, Loan Commitments Accounted for as Derivative Instruments (“SAB 105”), and expresses the view, consistent with the guidance in SFAS 156 and SFAS 159, that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB 105 also expressed the view that internally-developed intangible assets (such as customer relationship intangible assets) should not be recorded as part of the fair value of a derivative loan commitment. SAB 109 retains that view and broadens its application to all written loan commitments that are accounted for at fair value through earnings. Adoption of SAB 109 did not have a material effect on the Consolidated Financial Statements.

 

 

- 19 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Effect of Adoption. The table presented below summarizes the impact of adoption from the accounting developments summarized above on the results of operations:

 

 

 

 

 

Accumulated Other

 

 

 

 

 

 

 

Comprehensive

 

Retained Earnings

 

In millions

 

Date of Adoption

 

Income/(Loss)

 

Increase/(Decrease)

 

Year Ended November 30, 2007

 

 

 

 

 

SFAS 157

 

December 1, 2006

 

 

 

$

45

 

SFAS 158

 

November 30, 2007

 

$(210

)

 

 

 

SFAS 159

 

December 1, 2006

 

 

 

22

 

Six Months Ended May 31, 2008

 

 

 

 

 

FIN 48

 

December 1, 2007

 

 

 

(178

)

 

Elimination of QSPEs and Changes in the FIN 46(R) Consolidation Model. In April of 2008, the FASB voted to eliminate QSPEs from the guidance in SFAS 140 and to remove the scope exception for QSPEs from FIN 46(R). This will require that VIEs previously accounted for as QSPEs will need to be analyzed for consolidation according to FIN 46 (R). While the revised standards have not been finalized and the Board’s proposals will be subject to a public comment period, this change may affect the Company’s Consolidated Financial Statements as the Company may lose sales treatment for assets previously sold to a QSPE (i.e., no longer be able to de-recognize the assets from its Statement of Financial Condition), as well as for future sales. The proposed revisions could be effective as early as January 2009. The Company will continue to evaluate the impact of these changes on its financial statements once the changes to U.S. generally accepted accounting principles are completed.

 

The ASF Framework. On December 6, 2007, the American Securitization Forum (“ASF”), working with various constituency groups as well as representatives of U.S. federal government agencies, issued the Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans (the “ASF Framework”). The ASF Framework provides guidance for servicers to streamline borrower evaluation procedures and to facilitate the use of foreclosure and loss prevention efforts in an attempt to reduce the number of U.S. subprime residential mortgage borrowers who might default in the coming year because the borrowers cannot afford to pay the increased loan interest rate after their U.S. subprime residential mortgage variable loan rate resets. The ASF Framework requires a borrower and its U.S. subprime residential mortgage variable loan to meet specific conditions to qualify for a modification under which the qualifying borrower’s loan’s interest rate would be kept at the existing rate, generally for five years following an upcoming reset period. The ASF Framework is focused on U.S. subprime first-lien adjustable-rate residential mortgages that have an initial fixed interest rate period of 36 months or less, are included in securitized pools, were originated between January 1, 2005 and July 31, 2007, and have an initial interest rate reset date between January 1, 2008 and July 31, 2010 (defined as “Segment 2 Subprime ARM Loans” within the ASF Framework). On June 11, 2008, ASF revised the ASF Framework to permit application, in appropriate circumstances, to any rate reset on Segment 2 Subprime ARM Loans rather than only the initial rate reset.

 

On January 8, 2008, the SEC’s Office of Chief Accountant (the “OCA”) issued a letter (the “OCA Letter”) addressing accounting issues that may be raised by the ASF Framework. Specifically, the OCA Letter expressed the view that if a Segment 2 Subprime ARM Loan is modified pursuant to the ASF Framework and that loan could legally be modified, the OCA will not object to continued status of the transferee as a QSPE under SFAS 140. Concurrent with the issuance of the OCA Letter, the OCA requested the FASB to immediately address the issues that have arisen in the application of the QSPE guidance in SFAS 140. Any loan modifications the Company makes in accordance with the ASF Framework will not have a material impact on its accounting for U.S. subprime residential mortgage loans nor securitizations or retained interests in securitizations of U.S. subprime residential mortgage loans.

 

At May 31, 2008, the Company has not yet modified a significant volume of loans using the ASF Framework. Additionally and at May 31, 2008, the Company does not believe its application of the ASF Framework will impact the off-balance sheet status of the Company sponsored QSPEs that hold Segment 2 Subprime ARM Loans.

 

Basel II. As of December 1, 2005, the Company became regulated by the SEC as a consolidated supervised entity (“CSE”). This supervision subjects the Company to group-wide supervision and examination by the SEC, minimum capital requirements on a consolidated basis and reporting (including reporting of capital adequacy measurement consistent with the standards adopted by the Basel Committee on Banking Supervision) and notification requirements. CSE capital requirements for the Company are principally driven by market, credit and operational risk amounts computed using methodologies developed by the Company and approved by the SEC.

 

 

- 20 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

The Basel Committee on Banking Supervision published an updated framework to calculate risk-based capital requirements in June 2006 (“Basel II”). In September 2006, U.S. federal bank regulators announced their intent to implement Basel II in the U.S. On December 10, 2007, the U.S. federal bank regulators published final rules to implement new risk-based capital requirements in the U.S. for large, internationally active (core) banking organizations.

 

The CSE regulations are intended to provide consolidated supervision of investment bank holding companies that is broadly consistent with U.S. federal bank regulatory oversight of bank holding companies. Basel II is meant to be applied on a consolidated basis for banking institutions or bank holding companies that have consolidated total assets of $250 billion or more and/or consolidated total on-balance-sheet foreign exposure of $10 billion or more. Basel II provides two broad methods for calculating minimum capital requirements related to credit risk: (i) a standardized approach that relies heavily upon external credit assessments by major independent credit rating agencies; and (ii) an internal ratings-based approach, at foundation or advanced levels that permits the use of internal rating assessments in determining required capital.

 

Beginning January 2008, certain of the Company’s subsidiaries in Europe, became subject to the Basel II requirements. The time frame in which Basel II requirements would become effective for U.S. banking institutions or bank holding companies is contemplated to be on or after (i) completion of four consecutive quarterly parallel calculations, in which an entity would remain subject to existing risk-based capital rules but also calculate its risk-based capital requirements under the new Basel II framework; and (ii) a series of transitional periods during which an entity would report under the new framework, subject to supervisory mandated minimum regulatory capital requirements.

 

Additionally, and as an increasing number of global banking organizations become subject to Basel II, new interpretations may arise, and harmonization among regulators could impact the regulatory capital standards under which the Company operates as a CSE, as well as the requirements for some of the Company’s regulated subsidiaries. For further discussion of the Company’s CSE capital ratios, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations— CSE Regulatory Capital” in this Report.

 

 

Note 2 Business and Geographic Segments

 

 

Business Segments

 

The Company organizes its business operations into three business segments: Capital Markets, Investment Banking and Investment Management.

 

The business segment information for the periods ended May 31, 2008 and 2007 is prepared using the following methodologies and generally represents the information that is relied upon by management in its decision-making processes:

 

·                 Revenues and expenses directly associated with each business segment are included in determining income before taxes.

 

·                 Revenues and expenses not directly associated with specific business segments are allocated based on the most relevant measures applicable, including each segment’s revenues, headcount and other factors.

 

·                 Net revenues include allocations of interest revenue, interest expense and revaluation of certain long-term and short-term debt measured at fair value to securities and other positions in relation to the cash generated by, or funding requirements of, the underlying positions.

 

·                 Business segment assets include an allocation of indirect corporate assets that have been fully allocated to the segments, generally based on each segment’s respective headcount figures.

 

Capital Markets

 

The Capital Markets segment is divided into two components:

 

Fixed Income — The Company makes markets in and trades municipal and public sector instruments, interest rate and credit products, mortgage-related securities and loan products, currencies and commodities. The Company also originates mortgages and structures and enters into a variety of derivative transactions. The Company provides research covering economic, quantitative, strategic, credit, relative value, index and portfolio analyses. Additionally, the Company provides financing, advice and servicing activities to the hedge fund community, known as prime brokerage services. The Company engages in certain proprietary trading activities and in principal investing in real estate that are managed within this component.

 

 

- 21 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Equities — The Company makes markets in and trades equities and equity-related products and enters into a variety of derivative transactions. The Company also provides equity-related research coverage as well as execution and clearing services for clients. Through capital markets prime services, the Company provides prime brokerage services to the hedge fund community. The Company also engages in proprietary trading activities and private equity and other related investments.

 

Investment Banking

 

The Company takes an integrated approach to client coverage, organizing bankers into industry, product and geographic groups within the Investment Banking segment. Business services provided to corporations and governments worldwide can be separated into:

 

Global Finance — The Company serves clients’ capital raising needs through underwriting, private placements, leveraged finance and other activities associated with debt and equity products.

 

Advisory Services — The Company provides business advisory services with respect to mergers and acquisitions, divestitures, restructurings and other corporate activities.

 

Investment Management

 

The Investment Management business segment consists of:

 

Asset Management — The Company provides customized investment management services for high net worth clients, mutual funds and other institutional investors. Asset Management also serves as general partner for private equity and other alternative investment partnerships and has minority stake investments in certain alternative investment managers.

 

Private Investment Management — The Company provides investment, wealth advisory and capital markets execution services to high net worth and institutional clients.

 

Business Segments

 

In millions

Capital
Markets

Investment
Banking

Investment
Management

Total

Three Months Ended May 31, 2008

 

 

 

 

 

 

 

Gross revenues

$

4,522

 

$

858

 

$

860

 

$

6,240

 

Interest expense

6,896

 

 

12

 

6,908

 

Net revenues

(2,374

)

858

 

848

 

(668

)

Depreciation and amortization expense

121

 

14

 

30

 

165

 

Other expenses

2,014

 

651

 

589

 

3,254

 

Income before taxes

$

(4,509

)

$

193

 

$

229

 

$

(4,087

)

Segment assets (in billions)

$

629.3

 

$

1.3

 

$

8.8

 

$

639.4

 

Three Months Ended May 31, 2007

 

 

 

 

 

 

 

 

Gross revenues

$

13,616

 

$

1,150

 

$

813

 

$

15,579

 

Interest expense

10,022

 

 

45

 

10,067

 

Net revenues

3,594

 

1,150

 

768

 

5,512

 

Depreciation and amortization expense

109

 

12

 

26

 

147

 

Other expenses

2,132

 

800

 

554

 

3,486

 

Income before taxes

$

1,353

 

$

338

 

$

188

 

$

1,879

 

Segment assets (in billions)

$

595.5

 

$

1.3

 

$

9.1

 

$

605.9

 

 

 

 

- 22 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

In millions

Capital
Markets

Investment
Banking

 

Investment
Management

 

Total

Six Months Ended May 31, 2008

 

 

 

 

 

 

Gross revenues

$

15,033

 

$

1,725

 

$

1,852

 

$

18,610

 

Interest expense

15,736

 

 

35

 

15,771

 

Net revenues

(703

)

1,725

 

1,817

 

2,839

 

Depreciation and amortization expense

237

 

28

 

60

 

325

 

Other expenses

3,332

 

1,323

 

1,283

 

5,938

 

Income before taxes

$

(4,272

)

$

374

 

$

474

 

$

(3,424

)

Segment assets (in billions)

$

629.3

 

$

1.3

 

$

8.8

 

$

639.4

 

Six Months Ended May 31, 2007

 

 

 

 

 

 

 

 

Gross revenues

$

25,838

 

$

2,000

 

$

1,536

 

$

29,374

 

Interest expense

18,742

 

 

73

 

18,815

 

Net revenues

7,096

 

2,000

 

1,463

 

10,559

 

Depreciation and amortization expense

211

 

22

 

51

 

284

 

Other expenses

4,163

 

1,450

 

1,084

 

6,697

 

Income before taxes

$

2,722

 

$

528

 

$

328

 

$

3,578

 

Segment assets (in billions)

$

595.5

 

$

1.3

 

$

9.1

 

$

605.9

 

 

Geographic Net Revenues

 

The Company organizes its operations into three geographic regions:

 

·      Europe and the Middle East, inclusive of operations in Russia and Turkey;

 

·      Asia-Pacific, inclusive of operations in Australia and India; and

 

·      the Americas.

 

Net revenues presented by geographic region are based upon the location of the senior coverage banker or investment advisor in the case of Investment Banking or Asset Management, respectively, or where the position was risk managed within Capital Markets and Private Investment Management. Certain revenues associated with U.S. products and services that result from relationships with international clients have been classified as international revenues using an allocation process. The methodology for allocating the Firm’s revenues to geographic regions is dependent on the judgment of management. Additionally, because certain components of revenues reflect the overall performance of the Company as well as the performance of individual business units, performance in one segment may be affected by the performance of other segments.

 

The following presents, in management’s judgment, a reasonable representation of each region’s contribution to net revenues.

 

Geographic Net Revenues

 

 

Three Months Ended May 31,

 

Six Months Ended May 31,

 

In millions

2008

 

2007

 

2008

 

2007

 

Europe and the Middle East

$

(499

)

$

1,829

 

$

261

 

$

3,197

 

Asia-Pacific

57

 

762

 

1,405

 

1,356

 

Total Non-Americas

(442

)

2,591

 

1,666

 

4,553

 

U.S.

(290

)

2,888

 

1,052

 

5,916

 

Other Americas

64

 

33

 

121

 

90

 

Total Americas

(226

)

2,921

 

1,173

 

6,006

 

Net revenues

$

(668

)

$

5,512

 

$

2,839

 

$

10,559

 

 

 

 

- 23 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 3 Financial Instruments and Other Inventory Positions

 

Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased were comprised of the following:

 

 

Owned

 

Sold But Not Yet Purchased

In millions

May 31, 2008

 

Nov 30, 2007

 

May 31, 2008

Nov 30, 2007

Mortgage and asset-backed securities

$

72,461

 

$

89,106

 

$

351

 

$

332

 

Government and agencies

26,988

 

40,892

 

63,731

 

71,813

 

Corporate debt and other

49,999

 

54,098

 

8,344

 

6,759

 

Corporate equities

47,549

 

58,521

 

43,184

 

39,080

 

Real estate held for sale

20,664

 

21,917

 

 

 

Commercial paper and other money market instruments

4,757

 

4,000

 

12

 

12

 

Derivatives and other contractual agreements

46,991

 

44,595

 

25,885

 

31,621

 

 

$

269,409

 

$

313,129

 

$

141,507

 

$

149,617

 

 

Mortgage and asset-backed securities. Mortgage and asset-backed securities include residential and commercial whole loans and interests in residential and commercial mortgage-backed securitizations. Also included within Mortgage and asset-backed securities are securities whose cash flows are based on pools of assets in bankruptcy-remote entities, or collateralized by cash flows from a specified pool of underlying assets. The pools of assets may include, but are not limited to mortgages, receivables and loans. Additionally, the Company’s mortgage-related trading positions consist of loans purchased as non-performing loans, equity interests in commercial properties and asset-backed securities that are backed by mortgage loans or other assets.

 

It is the Company’s intent to sell through securitization or syndication activities, residential and commercial mortgage whole loans the Company originates, as well as those acquired in the secondary market. The Company originated approximately $0.5 billion and $2 billion of residential mortgage loans for the three and six months ended May 31, 2008, respectively, compared to the $17 billion and $32 billion for the three and six months ended May 31, 2007, respectively. The Company originated approximately $2 billion and $4 billion of commercial mortgage loans for the three and six months ended May 31, 2008, respectively, compared to the $19 billion and $32 billion for the three and six months ended May 31, 2007, respectively.

 

Balances reported for Mortgage and asset-backed securities include approximately $11.7 billion and $11.9 billion at May 31, 2008 and November 30, 2007, respectively, of loans transferred to securitization vehicles where such transfers were accounted for as secured financings rather than sales. The securitization vehicles issued securities that were distributed to investors. The Company considers itself to have economic exposure only to the securities retained from those securitization vehicles; the Company does not have economic exposure to the underlying assets in those securitization vehicles. For further discussion of securitization activities, see Note 6, “Securitizations and Special Purpose Entities,” to the Consolidated Financial Statements.

 

 

- 24 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

At May 31, 2008 and November 30, 2007, the Company’s inventory of Mortgage and asset-backed-related positions, excluding those to which the Company does not have economic exposure, which were approximately $11.7 billion and $11.9 billion at May 31, 2008 and November 30, 2007, respectively, generally included the following types of assets:

 

In millions

May 31, 2008

 

November 30, 2007

 

Residential:

 

 

 

 

 

Securities(1)

$

14,986

 

 

$

16,709

 

Whole loans

8,250

 

 

14,235

 

Servicing and other

1,666

 

 

1,235

 

 

$

24,902

 

 

$

32,179

 

Commercial:

 

 

 

 

 

Whole loans

$

19,862

 

 

$

26,200

 

Securities and other(2)

9,528

 

 

12,738

 

 

$

29,390

 

 

$

38,938

 

 

 

 

 

 

 

Other asset-backed(3)

$

6,482

 

 

$

6,163

 

Total

$

60,774

 

 

$

77,280

 

 

(1)

At May 31, 2008, includes approximately $5.3 billion of investment grade interests in securitizations which the Company underwrote (“retained interests”); approximately $1.2 billion of non-investment grade retained interests in securitizations; and the remaining portion were acquired by the Company in the secondary market. At November 30, 2007, includes approximately $7.1 billion of investment grade retained interests in securitizations); approximately $1.6 billion of non-investment grade retained interests in securitizations; and the remaining portion were acquired by the Company in the secondary market.

 

 

(2)

At May 31, 2008, includes approximately $1.6 billion of investment grade interests in securitizations which the Company originated and $0.1 billion of non-investment grade retained interests in securitizations at May 31, 2008; and the remaining portion were acquired by the Company in the secondary market. At November 30, 2007, includes approximately $2.4 billion of investment grade retained interests in securitizations; approximately $0.03 billion of non-investment grade retained interests in securitizations; and the remaining portion were acquired by the Company in the secondary market.

 

 

(3)

Included within this line are securities as well as whole loans. Specifically, these positions include franchise-related whole business financings, small business loans, and various asset-backed positions related to student loans, credit cards and auto loans.

 

At May 31, 2008 and November 30, 2007, the Company’s portfolio of U.S. subprime residential mortgages, excluding those to which the Company does not have economic exposure, generally included the following types of assets:1

 

In millions

May 31, 2008

 

November 30, 2007

 

U.S. residential subprime mortgages

 

 

 

 

 

Whole loans(1)

$

1,048

 

 

$

3,226

 

Securities

1,686

 

 

1,995

 

Other

21

 

 

55

 

Total

$

2,755

 

 

$

5,276

 

 

(1)

Excludes loans to which the Company does not have economic exposure, which were approximately $2.0 billion and $2.9 billion at May 31, 2008 and November 30, 2007, respectively.

 

Government and agencies. Included within these balances are instruments issued by a national government or agency thereof, denominated in the country’s own currency or in a foreign currency (e.g., sovereign) as well as municipals.

 

Corporate debt and other. Longer-term debt instruments, generally with a maturity date falling at least a year after their issue date, not issued by governments and may or may not be traded on major exchanges, are included within this component.

 

Non-derivative, physical commodities are reported as a component of this line item and were approximately $527 million and $308 million in May 31, 2008 and November 30, 2007, respectively.

 

Corporate equities. Balances generally reflect held positions in any instrument that has an equity ownership component, such as equity-related positions, public ownership equity securities that are listed on public exchanges, private equity-related positions and non-public ownership equity securities that are not listed on a public exchange.

 

 


1

The Company generally defines U.S. subprime residential mortgage loans as those associated with borrowers having a credit score in the range of 620 or lower using the Fair Isaac Corporation’s statistical model, or having other negative factors within their credit profiles. Prior to its closure in the third quarter of fiscal 2007, the Company originated subprime residential mortgage loans through BNC Mortgage LLC (“BNC”), a wholly-owned subsidiary of the Company’s U.S. regulated thrift Lehman Brothers Bank, FSB. BNC served borrowers with subprime qualifying credit profiles but also served borrowers with stronger credit history as a result of broker relationships or product offerings and such loans are also included in the Company’s subprime business activity. For residential mortgage loans purchased from other mortgage originators, the Company uses a similar subprime definition as for its origination activity. Additionally, second lien loans are included in the Company’s subprime business activity.

 

 

 

- 25 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Real estate held for sale. The Company makes equity and debt investments in entities (including voting-interest entities and VIEs) whose underlying assets are real estate. Real estate held for sale positions are reported by the Company at the lower of carrying amount or fair value less cost to sell. The Company consolidates those entities in which it either controls the entity under SFAS 94 or is the primary beneficiary in accordance with FIN 46(R). At May 31, 2008 and November 30, 2007, the Company had approximately $20.7 billion and $21.9 billion, respectively, of real estate positions (parcels of land and/or related physical property). The Company considers itself to have economic exposure only to its direct investments in these entities; the Company does not have economic exposure to the total underlying assets in these entities. The Company’s net investment positions related to real estate, excluding the amounts that have been consolidated but for which the Company does not have economic exposure, was approximately $10.4 billion and $12.8 billion at May 31, 2008 and November 30, 2007, respectively.

 

At May 31, 2008, the Company held approximately $2.6 billion of real estate-related positions that did not qualify as held for sale pursuant to SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, the Company recorded accumulated depreciation expense of approximately $80 million in the second quarter of 2008 for these assets. This expense represents the cumulative depreciation for those positions since their inception through May 31, 2008. This amount is a component of Other non-interest expenses in the Consolidated Statement of Income. These positions are reported by the Company at the lower of carrying amount or fair value less cost to sell. Of the approximately $2.6 billion, the amount that has been consolidated but for which the Company does not have economic exposure, was approximately $0.9 billion at May 31, 2008. Of the approximately $80 million of accumulated depreciation expense, approximately $32 million related to the $0.9 billion for which the Company does not have economic exposure.

 

Commercial paper and other money market instruments. Commercial paper and other money market instruments include short-term obligations, generally issued by financial institutions or corporations, with maturities within a calendar year of the financial statement date. These instruments may include promissory notes, drafts, checks and certificates of deposit.

 

Derivatives and other contractual agreements. These balances generally represent future commitments to exchange interest payment streams or currencies based on contract or notional amounts or to purchase or sell other financial instruments or physical assets at specified terms on a specified date. Both over-the-counter and exchange-traded derivatives are reflected.

 

The following table presents the fair value of Derivatives and other contractual agreements at May 31, 2008 and November 30, 2007. Assets included in the table represent unrealized gains, net of unrealized losses, for situations in which the Company has a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties. The fair value of derivative contracts represents net receivable/payable for derivative financial instruments before consideration of securities collateral. Asset and liabilities are presented below net of cash collateral of approximately $23.8 billion and $21.6 billion, respectively, at May 31, 2008 and $19.7 billion and $17.5 billion, respectively, at November 30, 2007.

 

Fair Value of Derivatives and Other Contractual Agreements

 

 

May 31, 2008

 

November 30, 2007

 

In millions

Assets

Liabilities

 

Assets

Liabilities

 

Over-the-Counter: (1)

 

 

 

 

 

 

Interest rate, currency and credit default swaps and options

$

25,648

$

9,733

 

$

22,028

$

10,915

 

Foreign exchange forward contracts and options

2,383

2,270

 

2,479

2,888

 

Other fixed income securities contracts (including TBAs and forwards)

10,341

5,692

 

8,450

6,024

 

Equity contracts (including equity swaps,warrants and options)

6,022

6,391

 

8,357

9,279

 

Exchange Traded:

 

 

 

 

 

 

Equity contracts (including equity swaps,warrants and options)

2,597

1,799

 

3,281

2,515

 

 

$

46,991

$

25,885

 

$

44,595

$

31,621

 

 

(1)

The Company’s net credit exposure for OTC contracts is $37.4 billion and $34.6 billion at May 31, 2008 and November 30, 2007, respectively, representing the fair value of OTC contracts in a net receivable position, after consideration of collateral.

 

At May 31, 2008, commodity derivative assets and liabilities were $4.1 billion and $3.4 billion, respectively. At November 30, 2007, commodity derivative assets and liabilities were both approximately $1.5 billion.

 

Concentrations of Credit Risk

 

A substantial portion of securities transactions are collateralized and are executed with, and on behalf of, financial institutions, which includes other brokers and dealers, commercial banks and institutional clients. The Company’s exposure to credit risk associated with the non-performance of these clients and counterparties in fulfilling their contractual obligations with respect to various types of transactions can be directly affected by volatile or illiquid trading markets, which

 

 

 

- 26 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

may impair the ability of clients and counterparties to satisfy their obligations to the Company.

 

Financial instruments and other inventory positions owned include U.S. government and agency securities, and securities issued by non-U.S. governments, which in the aggregate represented 4% and 6% of total assets at May 31, 2008 and November 30, 2007, respectively. In addition, collateral held for resale agreements represented approximately 27% and 24% of total assets at May 31, 2008 and November 30, 2007, respectively, and primarily consisted of securities issued by the U.S. government, federal agencies or non-U.S. governments. The Company’s most significant industry concentration is financial institutions, which includes other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of business.

 

Note 4 Fair Value of Financial Instruments

 

Financial instruments and other inventory positions owned, excluding Real estate held for sale, and Financial instruments and other inventory positions sold but not yet purchased, are presented at fair value. In addition, certain long and short-term borrowing obligations, principally certain hybrid financial instruments, and certain deposit liabilities at banks, are presented at fair value.

 

Fair value is defined as the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties. A liability’s fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. In instances where valuation models are applied, inputs are correlated to a market value, combinations of market values or the Company’s proprietary data. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.

 

Assets and liabilities recorded at fair value in the Consolidated Statement of Financial Condition are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:

 

Level 1 — Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market (e.g., an equity security traded on the New York Stock Exchange) provides the most reliable fair value measurement because it is directly observable to the market. The types of assets and liabilities valued based on quoted market prices in active markets and categorized by the Company as Level 1 within the fair value hierarchy generally include equities listed in active markets, G-7 government and agency securities, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

 

Level 2 — Level 2 inputs are inputs that are observable, either directly or indirectly, but do not qualify as Level 1 inputs. Level 2 inputs may include:

 

·      Quoted prices for similar assets or liabilities in active markets.

 

·      Quoted prices for identical or similar assets or liabilities in markets that are not active, that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers (e.g., some brokered markets), or in which little information is released publicly (e.g., a principal-to-principal market).

 

·      Inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates).

 

·      Inputs that are derived principally from or corroborated by observable market data through correlation or by other means (market-corroborated inputs).

 

The types of assets and liabilities that trade in markets that are not considered to be active, but are valued based on quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include non-G-7 government securities, municipal bonds, certain hybrid financial instruments, certain mortgage and asset backed securities, certain corporate debt, certain commitments and guarantees, certain private equity investments, including equity interests in investment managers, and certain derivatives. Level 2 derivatives are valued using pricing models based on the net present value of estimated

 

 

 

- 27 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

future cash flows and directly observed prices from exchange-traded derivatives, other OTC derivative contracts, or external pricing services, while taking into account either the Company’s or counterparty’s creditworthiness, as appropriate. Determining the fair value for Level 2 derivative contracts can require a significant level of estimation and management judgment.

 

Financial instruments categorized as Level 2 within the SFAS 157 hierarchy are generally presented, at inception, using the transacted price. Thereafter, the Company generally values Level 2 assets and liabilities based upon comparable market prices or other relevant information from market transactions involving identical or comparable assets and liabilities.

 

Level 3 — Level 3 inputs reflect the Company’s assumptions that it believes market participants would use in pricing the asset or liability. The Company develops Level 3 inputs based on the best information available in the circumstances, which may include indirect correlation to a market value, combinations of market values or the Company’s proprietary data. Level 3 inputs generally include information derived through extrapolation or interpolation of observable market data.

 

At May 31, 2008, the Company included within Level 3 certain assets and liabilities that were components of the following inventory classifications:

 

·      Certain Mortgage and asset-backed securities which, at inception, may be reflected at the original transaction cost. However, they subsequently may be reflected at a value based upon valuation methodologies that incorporate a variety of inputs including prices observed from execution of a number of trades in the marketplace; ABX, CMBX and similar indices that track the performance of a series of credit default swaps based upon specific types of mortgages; and other market information, such as data on remittances received and updated cumulative loss data on underlying obligations. These asset types include mortgage whole loans, asset-backed securities, and private label or agency collateralized mortgage obligations.

 

·      Certain corporate debt positions which generally are initially presented at the original transaction price. Thereafter, the fair value of these positions are generally estimated by using executed transactions on comparable positions and anticipated market prices based upon pricing indications from syndicate banks and customers. The valuation of these positions also takes into account certain fee income, third-party credit ratings of counterparties and underlying movements in credit spreads of the counterparties. These asset types include non-performing loan portfolios, loans to counterparties that do not have correlation to market prices, and other loans held and awaiting securitization or syndication.

 

·      Certain corporate equities, generally unlisted or private placement positions, which generally are originally reflected at their transaction price. Thereafter, these positions are subsequently valued based on third-party investments, pending transactions or changes in financial ratios (e.g., earnings multiples). These asset types include private equity and principal investment positions in addition to equity interests in corporations or investment vehicles.

 

·      Derivative positions that were originally recorded based upon valuation models using initial trade prices. Changes in the valuations thereafter are not a result of changes in model methodology but changes in model inputs (e.g., interest rates, credit spreads and volatilities). Model inputs are updated only when those inputs can be corroborated with other market data. These asset types include interest rate option contracts, credit default swaptions, structured volatility derivatives and other forward starting contracts that are generally long-tenured.

 

The Company makes certain valuation adjustments (e.g., credit adjustments) at a portfolio level. In determining fair value, the Company considers both the credit risk of counterparties, as well as its own creditworthiness. The Company attempts to mitigate credit risk to third parties by entering into netting and collateral arrangements. Net exposure is then measured with consideration of a counterparty’s creditworthiness and is incorporated into the fair value of the respective instruments. In the calculation of the credit risk adjustment for derivatives, the Company attempts to use observable market credit spreads. The impact of our credit risk is incorporated into the fair valuation, even when credit risk is not readily observable in the pricing of an instrument, such as in OTC derivatives contracts.

 

Valuation allowances are generally recorded on an aggregate basis. For a portfolio of assets or liabilities, the Company attributes valuation adjustments to individual transactions for financial reporting purposes. Management believes the

 

 

 

- 28 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

methodology adopted to allocate valuation adjustments on a portfolio to individual positions is reasonable and consistently applied during the periods presented.

 

Fair Value on a Recurring Basis

 

Assets and liabilities measured at fair value on a recurring basis and which were categorized as Level 3 at May 31, 2008 and November 30, 2007 were approximately $37.9 billion, compared to $38.9 billion at November 30, 2007.

 

 

At

In millions

May 31, 2008

 

Nov 30, 2007

 

Level 3 assets

$

41,344

 

 

$

41,979

 

 

Less: Level 3 derivative liabilities

(3,433

)

 

(3,095

)

 

Level 3 assets (net derivatives)

$

37,911

 

 

$

38,884

 

 

 

Assets and liabilities measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations.

 

 

Assets at Fair Value as of May 31, 2008

In millions

Level 1

Level 2

Level 3

Total

Mortgage and asset-backed securities(1)

$

347

$

51,517

$

20,597

$

72,461

 

Government and agencies

11,002

15,986

26,988

 

Corporate debt and other

77

44,332

5,590

49,999

 

Corporate equities

26,785

10,606

10,158

47,549

 

Commercial paper and other money market instruments

4,757

4,757

 

Derivative assets(2)

2,597

39,395

4,999

46,991

 

 

$

45,565

$

161,836

$

41,344

$

248,745

 

 

 

Liabilities at Fair Value as of May 31, 2008

In millions

Level 1

Level 2

Level 3

Total

Mortgage and asset-backed securities

$

$

351

$

$

351

 

Government and agencies

60,689

3,042

63,731

 

Corporate debt and other

5

8,339

8,344

 

Corporate equities

42,356

828

43,184

 

Commercial paper and other money market instruments

12

12

 

Derivative liabilities(2)

1,799

20,653

3,433

25,885

 

 

$

104,861

$

33,213

$

3,433

$

141,507

 

 

(1)

Includes loans transferred to securitization vehicles where such transfers were accounted for as secured financings rather than sales of approximately $11.7 billion at May 31, 2008. The securitization vehicles issued securities that were distributed to investors. The Company does not have economic exposure to the underlying assets in those securitization vehicles beyond the Company’s retained interests. The loans are reflected as an asset within Mortgages and asset-backed positions and the proceeds received from the transfer are reflected as a liability within Other secured borrowings. These loans are classified as Level 2 assets.

 

 

(2)

Derivative assets and liabilities are presented on a net basis by level. Inter- and intra-level cash collateral, cross-product and counterparty netting at May 31, 2008 were approximately $45.6 billion and $43.4 billion, respectively.

 

 

 

- 29 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

 

Assets at Fair Value as of November 30, 2007

In millions

Level 1

Level 2

Level 3

Total

Mortgage and asset-backed securities(1)

$

240

$

63,914

$

24,952

$

89,106

 

Government and agencies

25,393

15,499

40,892

 

Corporate debt and other

324

50,692

3,082

54,098

 

Corporate equities

39,336

10,812

8,373

58,521

 

Commercial paper and other money market instruments

4,000

4,000

 

Derivative assets(2)

3,281

35,742

5,572

44,595

 

 

$

72,574

$

176,659

$

41,979

$

291,212

 

 

 

Liabilities at Fair Value as of November 30, 2007

In millions

Level 1

Level 2

Level 3

Total

Mortgage and asset-backed securities

$

$

332

$

$

332

 

Government and agencies

67,484

4,329

71,813

 

Corporate debt and other

22

6,737

6,759

 

Corporate equities

39,080

39,080

 

Commercial paper and other money market instruments

12

12

 

Derivative liabilities(2)

2,515

26,011

3,095

31,621

 

 

$

109,113

$

37,409

$

3,095

$

149,617

 

 

(1)

Includes loans transferred to securitization vehicles where such transfers were accounted for as secured financings rather than sales of approximately $11.9 billion. The securitization vehicles issued securities that were distributed to investors. The Company does not have economic exposure to the underlying assets in those securitization vehicles beyond the Company’s retained interests. The loans are reflected as an asset within Mortgages and asset-backed positions and the proceeds received from the transfer are reflected as a liability within Other secured borrowings. These loans are classified as Level 2 assets.

 

 

(2)

Derivative assets and liabilities are presented on a net basis by level. Inter- and intra-level cash collateral, cross-product and counterparty netting at November 30, 2007 was approximately $38.8 billion and $36.6 billion, respectively.

 

 

 

- 30 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Level 3 Gains and Losses

 

The tables presented below summarize the change in balance sheet carrying values associated with Level 3 Financial instruments for six months ended May 31, 2008 and May 31, 2007. Caution should be utilized when evaluating reported net revenues for Level 3 Financial instruments because the values presented exclude economic hedging activities that may be transacted in instruments categorized within other fair value hierarchy levels. Actual net revenues associated with Level 3 Financial instruments inclusive of hedging activities could differ materially.

 

 

Mortgage and asset-

 

Corporate

 

Corporate

 

 

 

 

In millions

backed securities

 

debt and other

 

equities

 

Net derivatives

 

Total

 

Balance at December 1, 2007

$

24,952

 

$

3,082

 

$

8,373

 

$

2,477

 

$

38,884

 

Net Payments, Purchases and Sales

(2,159

)

545

 

1,293

 

(8

)

(329

)

Net Transfers In/(Out)

31

 

2,094

 

164

 

(1,122

)

1,167

 

Gains/(Losses)(1)

 

 

 

 

 

 

 

 

 

 

Realized

(107

)

13

 

32

 

(137

)

(199

)

Unrealized

(2,120

)

(144

)

296

 

356

 

(1,612

)

Balance at May 31, 2008

$

20,597

 

$

5,590

 

$

10,158

 

$

1,566

 

$

37,911

 

 

 

Mortgage and asset-

 

Corporate

 

Corporate

 

 

 

 

In millions

backed securities

 

debt and other

 

equities

 

Net derivatives

 

Total

 

Balance at December 1, 2006

$

8,575

 

$

1,924

 

$

2,427

 

$

686

 

$

13,612

 

Net Payments, Purchases and Sales

4,020

 

478

 

1,187

 

277

 

5,962

 

Net Transfers In/(Out)

14

 

95

 

375

 

39

 

523

 

Gains/(Losses)(1)

 

 

 

 

 

 

 

 

 

 

Realized

450

 

50

 

26

 

55

 

581

 

Unrealized

(211

)

2

 

148

 

223

 

162

 

Balance at May 31, 2007

$

12,848

 

$

2,549

 

$

4,163

 

$

1,280

 

$

20,840

 

 

(1)

Realized or unrealized gains/(losses) from changes in values of Level 3 Financial instruments represent gains/(losses) from changes in values of those Financial instruments only for the period(s) in which the instruments were classified as Level 3.

 

The tables presented below summarize the change in balance sheet carrying values associated with Level 3 Financial instruments for the two quarterly periods completed to date for fiscal year 2008 and the four quarterly periods of fiscal year 2007. Caution should be utilized when evaluating reported net revenues for Level 3 Financial instruments because the values presented exclude economic hedging activities that may be transacted in instruments categorized within other fair value hierarchy levels. Actual net revenues associated with Level 3 Financial instruments inclusive of hedging activities could differ materially.

 

 

 

- 31 -


 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

 

 

Mortgage and asset-

 

Corporate

 

Corporate

 

 

 

 

 

In millions

 

backed securities

 

debt and other

 

equities

 

Net derivatives

 

Total

 

Balance at December 1, 2007

 

$    24,952

 

$   3,082

 

$  8,373

 

$  2,477

 

$  38,884

 

Net Payments, Purchases and Sales

 

46

 

524

 

360

 

73

 

1,003

 

Net Transfers In/(Out)

 

(519

)

655

 

(80

)

34

 

90

 

Gains/(Losses)(1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

83

 

24

 

27

 

(20

)

114

 

Unrealized

 

(750

)

(35

)

695

 

204

 

114

 

Balance at February 29, 2008

 

23,812

 

4,250

 

9,375

 

2,768

 

40,205

 

Net Payments, Purchases and Sales

 

(2,205

)

21

 

933

 

(81

)

(1,332

)

Net Transfers In/(Out)

 

550

 

1,439

 

244

 

(1,156

)

1,077

 

Gains/(Losses)(1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

(190

)

(11

)

5

 

(117

)

(313

)

Unrealized

 

(1,370

)

(109

)

(399

)

152

 

(1,726

)

Balance at May 31, 2008

 

$20,597

 

$ 5,590

 

$10,158

 

$1,566

 

$ 37,911

 

(1)           Realized or unrealized gains/(losses) from changes in values of Level 3 Financial instruments represent gains/(losses) from changes in values of those Financial instruments only for the period(s) in which the instruments were classified as Level 3.

 

 

 

Mortgage and asset-

 

Corporate

 

Corporate

 

 

 

 

 

In millions

 

backed securities

 

debt and other

 

equities

 

Net derivatives

 

Total

 

Balance at December 1, 2006

 

$

8,575

 

$

1,924

 

$

2,427

 

$

686

 

$

13,612

 

Net Payments, Purchases and Sales

 

2,349

 

428

 

210

 

283

 

3,270

 

Net Transfers In/(Out)

 

137

 

 

 

 

137

 

Gains/(Losses)(1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

176

 

19

 

21

 

7

 

223

 

Unrealized

 

(80

)

13

 

13

 

158

 

104

 

Balance at February 28, 2007

 

11,157

 

2,384

 

2,671

 

1,134

 

17,346

 

Net Payments, Purchases and Sales

 

1,671

 

50

 

977

 

(6

)

2,692

 

Net Transfers In/(Out)

 

(123

)

95

 

375

 

39

 

386

 

Gains/(Losses) (1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

274

 

31

 

5

 

48

 

358

 

Unrealized

 

(131

)

(11

)

135

 

65

 

58

 

Balance at May 31, 2007

 

12,848

 

2,549

 

4,163

 

1,280

 

20,840

 

Net Payments, Purchases and Sales

 

1,575

 

(299

)

545

 

(59

)

1,762

 

Net Transfers In/(Out)

 

9,856

 

(144

)

232

 

(160

)

9,784

 

Gains/(Losses) (1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

210

 

7

 

37

 

(4

)

250

 

Unrealized

 

(825

)

19

 

62

 

543

 

(201

)

Balance at August 31, 2007